The difference between interest rate risk measurement theory and practice

To keep her teaching certification current my wife attends various conferences and classes throughout the school year. While attending each session she confesses that, while she enjoys hearing about new ideas and strategies, she’s secretly wondering when the last time this person was actually in a classroom. Sounds good in theory, but have you actually tried this stuff? Every one of us has probably echoed this sentiment at one time or another… “Sounds like a good idea, but…”.

Interest rate risk measurement for community banks is one of those areas where there is a HUGE gap between theory and practice. Or at least, I think their should be. For years the ALM modeling world has been awash in terms like “shocks”, “ramps”, “twists”, “duration”, “interest rate elasticity”, “stochastic-modeling”, “Monte Carlo simulation”, blah, blah, blah. There are countless books and seminars offered that describe the “best” methods to use when measuring a bank’s interest rate risk.

It’s been my experience that, for most community banks, any additional IRR analysis beyond the standard +/-100bp, +/200bp, and +/-300bp shock is a practical waste of time. Now before the IRR measurement zealots out there start emailing me to tell me how shallow my thinking is, please note that I said “most” community banks, not all. And I said “practical” waste of time, not total waste of time.

There is additional information to be gained, but in most cases it’s only academically interesting. If my earnings at risk given a +200bp instantaneous shock is –8.5%, who cares if my earnings at risk given a rate ramp of +50bp per quarter is –7.1%? What’s the difference, –8.5% or –7.1%? If I’m a CFO or President of a community bank there isn’t any practical difference. I know in general that I’m at risk to rising rates. I know the severity of risk is in the neighborhood of 8%. I’m not going to make any substantial balance sheet management decisions based on this difference.

There is a practical limit to the amount of time and energy community banks can spend on IRR measurement. When the differences between using an instantaneous shock and some other approach become trivial, it’s time to stop the madness.